In an Uncertain World

by Robert Rubin

  In the next few weeks, we all felt the pressure. Jeff Shafer told me a story somewhat later about having a drink with friends before a baseball game at Camden Yards in Baltimore on a rare evening off. When a friend asked him something about the Mexican “bailout,” the term that most irritated us, Jeff’s response—“It was not a bailout!”—was loud enough to stop conversation in the crowded bar.

  I didn’t discuss my own feelings with anyone at work, but I too had focused on what the possibility of failure could mean for me. Losing $20 billion in public funds, especially on such a controversial and high-profile matter, could substantially taint how I would be seen as the Secretary of the Treasury. But even if I had to step down, I could deal with that. I felt better thinking that I’d helped set up the National Economic Council at the White House, which was working well. No one could take that away from me, no matter what happened afterward.

  As markets continued to fall, Larry and I had a difficult phone call with Guillermo Ortiz. This was after we had signed the agreement but just before the first disbursement of funds. As we explained how bleak the situation looked, Guillermo, though sounding overwrought, tried to paint a rosier scenario for us. We weren’t persuaded, but I understood he could do little else. After the call, we went right over to the Roosevelt Room in the White House for a meeting with Panetta and Berger. I felt, in light of the circumstances, that we had an obligation to raise the question of whether to exercise our right to withdraw from the arrangement unilaterally.

  “Letting Mexico go” at this stage would turn the possibility of default into a virtual sure thing—but I thought I should raise the issue even though I personally believed we should still proceed. My question was greeted with surprise. Only Erskine Bowles, the deputy chief of staff, who, like me, had worked as an investment banker, related to why I was even posing the possibility of not following through on this program we had already agreed to. Leon said that he didn’t think that option was viable. The administration was committed to a plan of action and had to stick with it even if the chance of failure had increased. The cost to the administration of reversing course—in terms of lost credibility—would be enormous. I, on the other hand, imagined the congressional hearing where I’d be called to account, with one of our very vocal critics leading the inquisition. So, Mr. Secretary, you thought that there was only a small chance that sending billions of dollars of American taxpayers’ money would help? And you sent the money anyway?

  That discussion illustrates a difference between making decisions on Wall Street and in government. There is a strong impetus to stick with presidential decisions, even when circumstances change, because the world is watching to see if you keep your commitments. Credibility and reliability are powerful values. Thus, changing direction may sometimes be worse than proceeding with something that could be wrong. In the private sector, reliability and credibility are also very important, but you can change course much more easily. When a Wall Street trader decides to cut his losses or a corporate head cuts back in a troubled business, no one complains about inconsistency. Nonetheless, there are times when high-profile government decisions should be reversed despite the damage to credibility. I didn’t think that was the case here, but I did think the issue should be raised.

  On March 9, the day we were to release the first $3 billion loan, the peso fell dramatically, closing for the first time at more than 7 pesos per dollar. Rumors—in this case accurate—circulated on Wall Street that we were contemplating not releasing the money on schedule. Despite the commitment of additional funds from the World Bank and the policy reforms that Ortiz was about to announce in Mexico City that evening, we were all deeply concerned that market confidence simply wasn’t going to rebound. But when the time came to decide, we approved the release of the money.

  The roller-coaster quality of that period was caught for me by the visit Larry and I paid the next day to the hearing room of the Senate Banking Committee. As I was answering questions, including hostile ones from Senators D’Amato and Lauch Faircloth (R-NC), my staff kept slipping me notes about the peso, which was rising even more dramatically than the prior day’s fall. Larry, who was testifying alongside me, passed me a note saying, “I think this thing might actually work.” While one of the senators was talking, I scribbled back a response: “I think it might.” Once again, though, our optimism was short-lived. The March 10 rally was followed by a steady decline. A month later, we went through the same agonizing decision again about whether to disburse the second $3 billion loan.

  By mid-May, the Mexican central bank data we saw showed the first, very tentative signs that the program was beginning to work, although markets didn’t seem to reflect much progress and still looked fragile. We sent a memo to the President that pointed to some encouraging indicators. The Mexican economy was in a severe recession, but the country’s trade deficit had turned into a surplus, the stock of outstanding Tesobonos had been reduced substantially, and the peso had recovered somewhat. Anticipating the success of our rescue package, Thomas Friedman, the Pulitzer Prize–winning New York Times columnist, described it in his May 24 column as “the least popular, least understood, but most important foreign policy decision of the Clinton presidency.”

  Alas, Friedman was getting ahead of himself just a bit. The roller coaster continued for the next few months. With the policy measures imposed by Zedillo, the financial and economic situation looked more stable by the end of the summer. But unemployment was growing, real wages had fallen significantly, and bank balance sheets were severely impaired. Chafing under the duress—and encouraged by signs that the program was taking hold—the Mexican government moved prematurely to lower interest rates. Markets resumed their slide, but the Mexicans quickly reacted and tightened policy to halt the slide.

  Despite another rocky period in November, by the end of 1995 the program was taking hold. Investors started to put some money in; foreign exchange reserves started to build up; exchange rates stabilized; interest rates came down a little bit. Everything just started to work. The private sector had begun lending Mexico money again. By the beginning of 1996, the Mexican economy was growing again. The Zedillo government began to repay the U.S. and IMF loans, rolling them over into less conditional private-sector debt.

  The speed of the response was remarkable. The 1982 crisis led to what has been called a “lost decade” of negative growth, financial instability, and political and social unrest throughout Latin America. The 1995 crisis caused real suffering on the part of the Mexican poor and middle class—and real wages were very slow to recover—but only one year of economic growth was lost. After the 1982 crisis, Mexico took seven years to regain access to capital markets. In 1995, it took seven months.

  In August 1996, Mexico prepaid $7 billion of the $10.5 billion still outstanding from the United States and IMF. When the Zedillo government completed the repayment in January 1997, more than three years ahead of schedule, an anonymous aide of mine was quoted in The New York Times as saying, “This was Bob Rubin’s Bosnia. And today he got the troops out.” Mexico paid us $1.4 billion dollars in interest and left the ESF with a profit of $580 million—the excess over what our money would have earned in U.S. Treasury notes. Senator D’Amato, who had already called the program a “failure,” put out a one-line press release saying he was “pleased” our program had been successful—thanks to “vigilant congressional oversight.”

  IT SEEMS TO ME that the Mexican crisis has much to teach us about the global economy, new and heightened risks that our country is likely to confront in the future, and the challenges we face in trying to deal with these hazards. These challenges are complicated by volatile financial markets and by our own political processes. I’ve drawn out many of those reflections in the context of my narrative, but a few final observations depend on the whole story.

  The first lesson is that our ability to address economic crises beyond our borders is limited. The money we lent to Mexico could not have had the desired effect without t
he policy choices the Mexican government made. This was the crucial element, both because of the effects of individual policies—especially on interest rates—and because of the confidence engendered by the more amorphous cumulative sense that the Mexicans were serious about getting their act together.

  As an episode in public policy making, our decision making in the face of a highly uncertain situation and considerable political pressure showed that the probabilistic thinking that I internalized so deeply in the financial world had real applicability in Washington. And that process was ongoing, as we reevaluated options and policies when the facts changed on the ground in Mexico and in the financial markets. I think, too, that our work demonstrated the value of robust and open intellectual interchange in making government decisions.

  Yet in other ways the episode showed me just how challenging decision making is in the context of government. Good decisions are much more difficult to make when disagreement is not just about means but about objectives. The private sector often focuses intensely on customers and employees, but in the final analysis everything comes back to serving the overriding objective of profitability—except perhaps for the relatively small portion of corporate activity devoted to philanthropy and other public purposes. The public sector, by contrast, operates with many equally legitimate objectives. For many in Congress, narcotics and illegal immigration mattered far more than economic issues in dealing with Mexico, and these legislators were not persuaded by our argument that the former problems would get far worse if Mexico defaulted and suffered from severe and prolonged economic duress.

  Mexico also demonstrated the difficulties our political processes have in dealing effectively with issues that involve technical complexities, shorter-term cost to achieve longer-term gain, incomplete information and uncertain outcomes, opportunities for political advantage, and inadequate public understanding. Unfortunately, many of the most important economic, geopolitical, and environmental challenges of today’s complicated world fit this profile, raising the question of how effectively our political system will be able to deal with them.

  Having said that, the Mexican crisis also showed the strength of our system. Congress, while not able to act itself and often complicating our efforts, also induced greater focus on some important issues, such as moral hazard, and helped assure that all points of view were considered, a value often lost in a more monolithic system. In addition, some individual legislators were tremendously helpful. As I discovered, finding effective legislative allies is key to navigating our system successfully. At one point, Senator D’Amato had proposed measures that would rule out future Treasury use of the ESF in this type of situation—which would have severely hampered us in dealing with the Asian crisis two years later. But Senators Dodd and Sarbanes, who had a deep understanding of the benefits and risks of the global financial system, filibustered D’Amato’s language, which led to a more limited constraint. I also remember an act of graciousness of the kind that occurs too seldom in any walk of life. Frank Murkowski, a Republican senator from Alaska and a former banker, who had opposed our rescue package as unlikely to work, went out of his way when I was testifying later at a hearing on another matter to say that he had been wrong—a gesture unusual in Washington and most other places.

  However, Murkowski’s prediction could have turned out to be right. Our program could have been undertaken only by a President—and an administration—willing to take a major calculated risk, substantive and political. We could have failed because of a mistake in our analysis, but also because of unforeseeable circumstances, or simply the foreseeable risk actually occurring. If the odds are calculated accurately at three to one, you’ll lose one time in four. Unfortunately, Washington—the political process and the media—judges decisions based solely on outcomes, not on the quality of the decision making, and makes little allowance for the inevitability of some level of human error. This can easily lead to undue risk aversion on the part of public officials. The same issue exists in the private sector—in my own experience, most seriously in judging trading and investing results. But the private sector somewhat more frequently recognizes the need to look beyond the outcome to reach the most sensible and constructive evaluation.

  Some years later, Paul O’Neill, the Bush administration’s newly appointed Treasury Secretary, said he liked the Mexican program because it worked. “We gave them money, it stabilized their situation, and they paid back the money ahead of schedule,” he said. “I like success. I’m not a real fan of even well-meaning failure.” Where O’Neill said he liked what worked, my view was that decisions shouldn’t be evaluated only on the basis of results. Even the best decisions about intervention are probabilistic and run a real risk of failure, but the failure wouldn’t necessarily make the decision wrong.

  Finally, what concerns me most is how little the public understands the impact that all of the issues around globalization and economic conditions elsewhere have on jobs, living standards, and growth in this country and how critical U.S. leadership is on these international economic matters. The result, as I realized over and over again during my six and a half years in Washington, is that public support—and thus political support—for trade liberalization, international financial-crisis response, foreign aid, funding for the World Bank and the IMF, and the like—is at best very difficult to obtain.

  At one point during the second term, Secretary of State Madeleine Albright and I discussed holding joint public meetings around the country to try to improve public understanding of how global issues, both economic and geopolitical, affect people’s lives. Regrettably, we never did this, but some kind of ongoing public education campaign is badly needed to change the politics around all these concerns, which are so critical to our future. On trade, for example, dislocations are very specific and keenly felt—and lead to strong political action—but the benefits of both exports and imports are widely dispersed and not recognized as trade-related, and thus haven’t developed the level of political support they require.

  We also face significant challenges when it comes to the international politics of economic leadership. In Mexico, and later in the Asian financial crisis, U.S. leadership, exercised in correlation with the G-7, the IMF, the World Bank, and others, was necessary for effective response. But even our closest allies are ambivalent about the role of the United States. We are criticized if we don’t lead and resented if we do. At Treasury, the lesson we took was to work all the more energetically with other countries to reach consensus whenever practical, which often meant making accommodations on our part. But we also recognized that at times we would feel a need to push beyond where others wanted to go.

  In 1995, I referred to the Mexican crisis as a “very low-probability event.” But my view later changed. The likelihood of a contagious crisis emanating from problems in any one developing country may ordinarily be small. But modern capital markets—with their many interrelationships, size, and speed—combined with the inherent human tendency to go to excess, create a seemingly inevitable tendency toward periodic destabilization that is difficult to anticipate and prevent. Indeed, only a couple of years later, I found myself immersed in another global financial crisis—one far more threatening in its scale, complexity, and potential consequences than what had happened in Mexico.

  CHAPTER TWO

  A Market Education

  IWAS AN ODD CHOICE for Goldman Sachs when the firm hired me, at the age of twenty-eight, to work in its storied arbitrage department. Nothing about my demeanor or my experience would have suggested I might be good at such work. The stereotypical personality type of the arbitrageur was, in those days, forceful and confrontational. I was then, as now, a low-key, not manifestly aggressive person. As for my qualifications, I don’t think I’d even ever heard the phrase “risk arbitrage” before I started the job search that led to Goldman Sachs. But as it happened, arbitrage and I turned out to be a pretty good fit.

  Arbitrage in its classic form is nothing more complicated th
an attempting to profit by buying something in one market and then selling it at the same time in another market for a price differential. As practiced in the years before the Second World War, when communication advantages were still possible, classic arbitrage meant trying to capture discrepancies in different financial markets. To take a simple example, the British pound might have been trading at $2.42 in London and $2.43 in New York. If an arbitrageur could buy pounds in London and sell them in New York simultaneously, he would be assured a profit of $1 for every $242 he put up. The only risk in this kind of arbitrage is not completing the transaction fast enough. During the first half of the century, many firms made a steady income from the minor price differentials for the same currencies and securities trading in different markets.

  As global communications improved, however, the profit went out of traditional arbitrage. Once everyone knew in real time what the pound was trading at on various markets, the discrepancies became, for the most part, too small to be worth exploiting. But in the years after the Second World War, Gustave Levy, the man I would work for a couple of decades later at Goldman Sachs, helped develop a new business known as “risk arbitrage.” In classic arbitrage you buy and sell the same thing simultaneously. In the simplest form of risk arbitrage, you buy one stock—call it A—that will be converted into another stock—B—once an already announced event, such as a merger, is completed. At the same time as the purchase, you sell B in order to “hedge” the transaction and lock in your profit. There’s an element of risk, because the conversion of A into B isn’t certain—the deal might fall apart rather than close.

  Since the 1950s, risk arbitrage on Wall Street has meant buying securities that are the subject of some material event, like a merger, a tender offer, a breakup, divestiture, or a bankruptcy. As a hypothetical example, Big Company might announce a friendly takeover of Acme Industries at the price of one half of a share of BigCo’s stock for every Acme share. Say BigCo is trading at $32 per share. The stock of the target company was trading at $13 before the deal was announced and rose to $14.50 after the announcement, based on its being worth $16 per share once the deal is completed (one half of BigCo if it remained at $32). In a risk arbitrage transaction, you would buy shares of Acme and “sell short” the number of BigCo shares you would receive when the takeover closed. Short selling in this context means selling something now that you don’t yet own to hedge against market risk—in other words, to protect yourself against the possibility that by the time the item you’re buying (A) is converted into the item you’re selling (B), B will have gone down in value. (To sell something you don’t own, you have to borrow it for a fee.) Then when the deal closes, you simply take the shares of BigCo you received in exchange for your Acme shares and deliver them against the short, replacing what you borrowed and closing out the position. Your profit is the difference between the transaction price and the price you initially locked in. Movements of the BigCo stock subsequent to your short sale don’t matter—if BigCo goes down 5 points, it doesn’t affect you because you’ve already sold the BigCo stock short, locking in the spread against the Acme stock you’ve bought.